Asad Gourani, CFP®
Tax Credits vs Tax Deductions
Updated: Jan 18, 2021
For the average consumer, taxes can be a confusing subject. Professionals are throwing around terminologies that makes very little sense to those who are not in the industry. Understanding some of these basic terms can help you to make wiser decisions with your finances throughout the year. In particular, most people could benefit from understanding the major differences between a tax credit and a tax deduction.
If you have been wondering what the difference between these two categories is, it’s time to dive a little deeper into your taxes. You can be more prepared for next year’s tax season when you are armed with this knowledge.
What’s the Difference?
While the specifics can get a little tricky, the basic difference between a tax credit and a tax deduction is actually quite simple. A tax credit is a dollar for dollar reduction in your tax bill. While a tax deduction is a reduction in your overall taxable income. Both tax credits and tax deductions are significant when you file your taxes at the end of the year, yet they are not created equal.
If you were to compare a tax credit and a tax deduction of the same amount side by side, here is what it would look like:
Of course, this is just a starting point to understanding how these two categories affect your final tax bill each year, so let’s go a little deeper and take another look at the two main types of tax credits.
Tax Credits: A Closer Look
As you can see, there are definitely times when a tax credit can significantly impact your bottom line. In the chart above, you saved more than $7,000 by having a tax credit instead of an equivalent tax deduction. It might seem cut and dry, but there is actually a little more to it than that. There are really two different kinds of tax credits – refundable and non-refundable.
Everyone loves the idea of getting a huge paycheck from the federal government each spring. Refundable credits are one of several reasons why you might receive money back each spring. Having a refundable credit means that you will get a refund for the excess of your liability. That sounds pretty confusing, so let’s look at a real-world example: You owe $2,000 in taxes, but you have a refundable tax credit of $2,500. Because your tax credit was refundable, you will receive that extra $500 back into your pocket.
On the other hand, there are also non-refundable tax credits. In this case, you would not receive back any of the money from the credit, even if your liability is lower. From our above example, a non-refundable tax credit would offset your $2,000 liability but you would not get to pocket the extra $500.
Examples of Tax Credits
Some people are already familiar with many of the most popular tax credit programs. However, we are going to review a few of the ways that you could be saving on your taxes. This list is by no means comprehensive of all the potential tax credits available to you.
· Lifetime Learning Credit: This non-refundable tax credit is great for those who have dreams of pursuing higher education. You receive a tax credit up to $2,000 to cover the costs associated with any professional, undergraduate, or graduate degree program.
· American Opportunity Tax Credit: Unlike the Lifetime Learning Credit, the American Opportunity Tax Credit is partially refundable. Fortunately, the tax credit is also larger, coming in at $2,500 per student. These funds can be applied to tuition, books, and supplies for the first four years of undergraduate school.
· Child Tax Credit:You may not be able to plan for this one, but most taxpayers love the idea of getting money back for raising a kid. This refundable tax credit is worth up to $2,000 per child but is typically phased out for those who have higher income brackets.
· Saver’s Credit: This credit helps to offset the costs of contributing to an IRA account or an employer-sponsored plan for low to moderate income households. The credit is designed to incentivize contributions toward retirement goals.
How to Get Tax Deductions
Reducing your overall taxable income can certainly provide you with a few advantages when tax season comes around. There is more than one way to get tax deductions each year. At a very basic level, every single taxpayer is entitled to a standard deduction that serves as a one-size-fits all deduction. Some people may have more tax deductions than others, and this basic option does not make the most sense for their particular situation. Instead, they may choose to itemize their tax deductions line by line to end up with a bigger deduction.
What kind of things can you itemize on your taxes? The list is fairly lengthy, but here are some of the most common deductions:
· Medical expenses in excess of 10 percent of your adjusted gross income
· State and local taxes (SALT) that are capped at a $10,000 maximum
· Mortgage interest deduction on qualified loans up to $750,000 for married taxpayers filing jointly
· Charitable contributions (limited to 50 percent of adjusted gross income for cash contributions and 30 percent of gross income for property contributions)
Some other deductions exist as “above the line deductions.” This category of tax deductions reduces your adjusted gross income to help save you even more money. You might see popular categories surface here, including:
· Student loan debt
· Contributions to a 401(k) or another qualified plan
· Deductible IRA contributions
· Deductible portion of self-employment taxes
· Health savings account (HSA) contributions
The Bottom Line: Tax Credits vs Tax Deductions
As you can see, both tax credits and tax deductions play an important role when it comes to your taxes each year. Both have their benefits, so it’s important to understand the impact that each can make on your bottom line. Your final tax bill will be directly influenced by the tax credits and deductions that you can claim each year. This should be something that you consider throughout the year as you make decisions regarding your finances.